The ROI of ABC

A White Paper

Prepared by Armstrong Laing Group

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The ROI of ABC

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The ROI of ABC

Abstract

With three of the world‘s major economies (USA, UK and Japan) slowly

recovering from recession, and organisations finding it difficult to grow revenue,

m anagers have tended to shelve investments where the payback is either hard

to quantify or too far in the future. However they still need to take positive

action to improve their businesses now. Activity Based Management (ABM) has

been a feature in m any organisations‘ finance functions for over two decades,

primarily as a tool for identifying costs at product, custom er or process level.

While ABC has been adopted with varying degrees of enthusiasm, there is now

an increasing realisation that ABC is a critical piece in the decision-making

framework of today‘s corporations. Leading Analyst Gartner commented:

—There is renewed interest in activity-based costing. Although many enterprises dismissed

activity-based costing in the 1980‘s and 1990‘s as too complicated, many enterprises see

themselves as needing it now to support better planning and to support profitability

analysis“.

While traditional costing has tended to overlook the fixed costs of doing

business with customers and leads to a distorted view of customer profitability,

ABC is a proven methodology for identifying the most profitable customers,

products, regions and channels. ABC can also help companies identify under-

perform ing assets and non-value added activities so that they are able to realign

their resources to improve profitability.

Despite this many businesses have struggled to accurately m easure the returns

that they have gained from the insight that ABC has brought to their

management decision-m aking and how this has impacted the business.

In an overview of activity-based costing, global consulting organisation

Accenture reported on the impact an ABC project can have on an organisation‘s

financial performance:

—ABC/M can help to reduce a company‘s overall cost structure by as much as 3-5%… An

enhanced focus on higher margin and growth products and the pursuit of better markets

can translate to a 5% -15% increase in revenue.“

This paper reviews other empirical research and reported case studies, both of

which indicate positive returns, which can be substantial and realised very

quickly. The paper concludes with a methodology for measuring the return on an

ABC/M initiative together with a documented ROI m odel that ABC practitioners

can use to calculate their return on investment.

Gartner Inc. November 5, 2002

Accenture, CFO Project Vol. 2, October 2003

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The ROI of ABC

ABC/M in practice

There are two main reasons why managers undertake ABC/M projects: explicitly to save

costs, or more generally to provide support for decision-making at both the strategic and

operational level.

Initiatives to save costs may be variously described as downsizing, right-sizing, business

process reviews, re-engineering, process improvements, shared services or a host of

other titles. Regardless, the objective is to ensure that the enterprise has a resource base

that is efficient and cost-effective. These projects may be short-lived with the purpose of

achieving a step change in costs, or may be ongoing providing costing information to

drive continual improvements across the enterprise. By using ABC information,

organisations can make informed strategic decisions on such issues as:

•

Pricing products and services more accurately

•

Managing the product and customer portfolios to optimise profitability

•

Allocating corporate overheads including shared services more accurately

•

Optimising business processes and improving capacity utilisation

•

Benchmarking between departments/divisions/business units

Where the information generated by ABC/M is made available to front-line managers to

support their business decisions, it is common for them to quickly appreciate the value of

the insight that it provides, acting more confidently and driving the enterprise to ever-

higher levels of competitiveness. ABC/M initiatives can have a major impact on the key

financial drivers of maximising sales, increasing margins and optimising investments, all

of which impact shareholder value. However, demonstrating the return of an investment

in ABC/M is not always easy.

Appraising the potential return on ABM initiatives

Techniques for assessing the return on IT investments have been well documented and it

is widely recognised that companies that get the best value from IT investments are those

that adopt a rigorous approach to quantifying the benefits prior to making a purchase

decision.

In the example of a CRM application or budgeting software, identifying process

improvements and quantifying the financial benefits of those improvements can be quite

straightforward. However, ABC/M initiatives differ from most other IT investments

because:

•

ABC/M applications are not transactional systems and do not deliver any business

benefits themselves. It is the decisions that managers in the business make as a

result of having the information that creates the value.

•

Information from ABC/M can support both strategic decisions at the top of an

organisation and operational decisions further down the organisation. Few other IT

applications impact across an enterprise so widely.

Therefore a typical pre-purchase appraisal for an ABC/M initiative might take the following

steps:

Step 1: Quantify the cost of the ABC/M initiative

The first step is to quantify how much the organisation needs to invest in the ABC project.

This should include the cost of the application and maintenance; any additional

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The ROI of ABC

investment in hardware; staffing costs for project managers, support staff and external

business consultancy; implementation; and ongoing support.

Step 2: Identify opportunities to create value

Once all the project costs have been identified, managers then need to identify

opportunities within the organisation where value could be created by either increasing

revenues, decreasing cost or reducing capital requirements.

These can be wide ranging but could include:

•

Improvements in margin from more informed pricing and discounting

•

More effective marketing from knowing what types of customer are profitable

•

Cost savings from removing non-value added activities and improving key processes

•

Reductions in capital requirements due to removing unprofitable products, customers,

suppliers or business channels

Managers can then compare the value created by the project with that of other possible

investments available to the enterprise in order to take the investment decision.

Step 3: Quantify the benefits

In parts of the business where the key benefit of ABC/M investment is likely to be a

reduction in cost, quantifying the benefits is easier, but even here estimates are

necessary.

The adoption of ABC/M frequently allows more informed decisions on pricing and

discounting and estimates should be made of the likely improvement in margins.

In another example, ABC may be used to determine whether an internal process or

activity such as a Call Centre or the IT department should be outsourced. If the model

identifies that it would be more cost effective to outsource the Call Centre or the IT

department, then the cost savings should be taken into account when assessing the

return on investment of ABC.

There may be less obvious business benefits that ought to be quantified. Using ABC/M to

focus process improvements in a business may also improve customer service. This may

lead to increased customer satisfaction and lower customer attrition, which in turn might

lead to increased revenues. This is exactly the same logic used to justify many CRM

applications and is evidently more difficult to quantify than a simple cost saving. However,

if managers believe there is a significant opportunity to reduce attrition, the levels of

customer satisfaction and attrition should be measured so that realistic improvements can

be targeted and the impact on revenue modelled.

All of these different elements of cost savings, revenue gains and margin improvements

can then be brought together and modelled to show the value of the ABC/M initiative over

time. If this sounds highly speculative and you are still sceptical, rest assured this type of

appraisal has much in common with those used to justify investments in ERP and CRM

that cost considerably more than an investment in ABC/M. And, unlike investments in ERP

and CRM, enterprises can approach ABC/M in bite-sized chunks and start with a pilot

study in a single business unit in order to understand the type of returns that can be

enjoyed.

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The ROI of ABC

Reported returns for ABC/M investments œ Client Examples

Despite the time and effort taken to produce the pre-purchase justifications, post

implementation appraisals are rarely robust and documented results are not widespread.

Many managers state that ABC-supported decisions are hard to distinguish from others

that have led to improvements in their company‘s performance. Others may see their

adoption of ABC as a source of competitive advantage and are reluctant to share the

results.

However, there is a growing body of evidence both from academic research and from

enterprises themselves that show there is a positive ROI with ABC and that it can make a

substantial impact on business performance:

In the UK, Lancashire and Edwards in a review of ABC initiatives in life insurance,

found that ABC could deliver a 1000% payback, comparing the total costs of

implementation against the short term cost savings identified within the first two years

of implementation.

Activity Based Costing in the Insurance Industry, Lancashire, J. and Edwards,

D., Bacon & W oodrow

TNT Express UK

In 2002 the TPG Group had revenues of 11.78 billion euros, of which 4.35 billion euros

were due to the TNT Express division. TPG has always considered the Express division to

be most sensitive to downturns in the world‘s main economies and in recent years volume

growth has slowed. TNT UK has been using ABC since 1992, analysing their activities in

order to improve the quality of financial results and achieve a transparency of cost. TNT

uses the ABC information to manage customers, especially in terms of rate negotiations

and when providing a rate proposal to potential customers. Customers in turn appreciate

that TNT has a good understanding of the costs of servicing them, making the

negotiations more scientific. TNT managers are also able to pinpoint areas for action

rather than taking a —shotgun“ approach to pricing. As a result of having had the benefit

of Activity-Based Costing (ABC) to assist with yield and cost management, the Express

divisions delivered exceptional results in 2002. In the annual report that year the CEO

stated:

—In summary, despite slower growth in volumes, Express performance was excellent. The

fastest and most reliable approach grew EBITA by 51.5%, boosting margins from 4.0% in

2001 to 5.8% in 2002. Compliments to all the people in the Express division are well

deserved.“

Peter Bakker, CEO, TPG Annual Report 2002

In a sample of 65 enterprises with ABM programs and a control group of 139 without,

Professors Gagwin and Bouwman found that if they controlled for other business

improvements initiatives such as BPR and JIT that may be happening concurrently,

there was still a positive relationship between ABM and improvements in the

enterprise‘s performance as measured by ROI.

The Association Between ABC and Improvement in Financial Performance,

Gagwin, D. and Mouwman, M., University of Texas at Brownsville, School of

Business Research Colloquium, April 2000

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The ROI of ABC

Tech Data

Florida-based Tech Data Corporation is a leading global provider of IT products and

logistics, serving more than 100,000 technology resellers from offices in 26 countries

across North America, Canada, Central and Latin America, Europe and the Middle East.

The company has a record of delivering consistent earnings even during recent years

when macroeconomic forces have sent the market into reverse. From a peak of $20.4

billion in 2001, Tech Data saw revenues fall to $15.7bn for 2003, but managed to hold

sales and general expenses (SGA) before special charges to 3.89% of revenue, more than

a clear percentage point less than its biggest competitor.

Activity Based Costing (ABC) is a far-reaching business practice within Tech Data

companies. By the beginning of 2003, it had been implemented in eight countries (US,

UK, Germany, France, Austria, Holland, Belgium and Sweden) comprising approximately

80% of sales. ABC is so pervasive within Tech Data that Chief Executive Steve Raymund

gave it specific mention in the 2003 Annual Report:

—We first began applying and refining ABC methodologies in the US over three years ago,

providing substantial operational value and insight, and these capabilities are expected to

strengthen our European business for many years to come.“

Steve Raymund, Chief Executive, Tech Data Corporation, 2003 Summary Annual Report

By better understanding which business activities added value or not, Tech Data has been

able to focus business improvement initiatives in areas where there are the greatest

savings to be enjoyed. Front-line managers now have the cost information to justify

improvements they wish to make.

—In 2001 Tech Data attributed a 33% increase in Earnings Per Share in part to the

contribution ABC/M had made to its performance, noting that profitability in areas using

ABC/M was twice that of others.“

—Preparation For Hard Times Pays Off For Distributor“ Tampa Bay Business Journal, 2001

In a review of the potential of ABC published in the Harvard Business Review, authors

Ness and Cucuzza examined the experience of Chrysler in the USA and stated that the

cost savings can be enormous, up to 50 to 100 times the cost of the ABC

implementation in some of their sites.

The Full Potential of Activity Based Costing, Ness, J. and Cucuzza, T., Harvard

Business Review May 1995

Allied Irish Bank

Allied Irish Bank (AIB) is Ireland's largest financial services organisation with market

capitalisation of /11.4 billion and half-year, pre-tax profits of /609 million in 2000. AIB is

currently ranked 33 in the Footsie Euro Top 300 Retail Banks Index.

AIB wanted to develop an insight into product and customer profitability within its large

branch network, to enable informed decision-making based on a robust costing model.

From taking up an activity-based approach to cost management and business

improvement, AIB have gained tangible business and cost benefits, more than justifying

the cost of purchasing software, consulting and effort that has gone into this project. The

pilot study alone identified a number of business processes that have since been re-

engineered, resulting in cost savings equivalent to the cost of the software license.

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The ROI of ABC

DHL Worldwide Express has long been an advocate of ABC/M, which it uses to support

pricing decisions across 80% of the company. It is reported that each 1% profit

margin improvement generated $5 million in greater profits in 1999.

Player, S. and Cobble, C., Cornerstones of Decision Making, Profiles of

Enterprise ABM, Oakhill Press, 1999

Conclusion

Whilst not all ABC/M projects can be said to be successful, there is an increasing body of

evidence from both empirical research and case studies that investing in ABC/M delivers

demonstrable returns and the cost of the investment can be quickly recouped. This is

reassuring for managers as they are being encouraged to reappraise ABC/M at a time

where investment in IT and business systems is likely to be under ever greater scrutiny.

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The ROI of ABC

Appendix

ALG Software has drawn up an ROI calculator that ABC practitioners can use to identify

the costs and calculate the business benefits of deploying ABC, using a Net Present Value

(NPV) methodology to reflect the time value of money. Generally, if the NPV is positive,

the investment is considered advantageous.

Fig 1 œ front page of ALG ROI Calculator

If you would like to complete this model and calculate the ROI of your ABC project,

please email

info@algsoftware.com

In our experience, very few ABC projects actually include the activity —Performing ABC“

within the model, so managers have little idea as to the actual cost of running the project,

other than the initial start up costs. Yet as an activity within a business it can have quite

an impact: data must be collected from across the organisation several times a year; IT is

frequently called upon; the project manager produces regular reports; not forgetting the

cost in employing an ABC Project Manager and / or support staff, even if they have been

re-assigned from within the organisation. ALG‘s ROI Calculator collects this information to

give a more accurate picture of the true cost of running an ABC program over 12 months.

The information provided by ABC projects can be used to support various decisions in an

organisation. In completing this model the user needs to investigate each instance to

identify any reductions in costs or increases in revenue that can be attributed to decisions

that were informed by information produced by the ABC initiative.

A UK manufacturer recently completed this ROI model and identified an ROI of 3000% ,

with program costs recovered within less than a month of the project going live. Other

managers who have used this methodology and indeed this model, report that this is an

easier task than it may first appear and suggest estimating the benefits of major

initiatives first as these alone are capable of generating a substantial return.

It is ALG‘s contention that all ABC projects, if properly built, supported and maintained,

can generate positive ROI very quickly. Indeed, we would go so far as to say that if a

manager is unable to show a return on his investment within 12 months, then he or she is

doing something wrong!